Debt may make managers more disciplined

In the 1980s, in the midst of the leveraged buyout boom, a group of practitioners and academics, led by Michael Jensen at Harvard, developed and expounded a new rationale for borrowing, based upon improving firms' efficiency in the utilization of their free cash flows. Free cash flows represent cash flows made _

. , • , , Free Cash Flows (Jensen's): The on operations over which managers have

. free cash flows referred to here are the discretionary spending power - they may use them operating cash flows after taxes, but before to take projects, pay them out to stockholders or discretionary capital expenditures.

hold them as idle cash balances. The group argued that managers in firms that have substantial free cash flows and no or low debt have such a large cash cushion against mistakes that they have no incentive to be efficient in either project choice or project management. One way to introduce discipline into the process is to force these firms to borrow money, since borrowing creates the commitment to make interest and principal payments, increasing the risk of default on projects with sub-standard returns. It is this difference between the forgiving nature of the equity commitment and the inflexibility of the debt commitment that have led some to call equity a cushion and debt a sword.

The underlying assumptions in this argument are that there is a conflict of interest between managers and stockholders, and that managers will not maximize shareholder wealth without a prod (debt). From our discussion in chapter 2, it is clear that this assumption is grounded in fact. Most large U.S. corporations employ managers who own only a very small portion of the outstanding stock in the firm; they receive most of their income as managers rather than stockholders. Furthermore, evidence indicates that managers, at least sometimes, put their interests ahead those of stockholders.

The argument that debt adds discipline to the process also provides an interesting insight into management perspectives on debt. Based purely upon managerial incentives, the optimal level of debt may be much lower than that estimated based upon shareholder wealth maximization. Left to themselves, why would managers want to burden themselves with debt, knowing fully well that they will have to become more efficient and pay a larger price for their mistakes? The corollary to this argument is that the debt ratios of firms in countries in which stockholder power to influence or remove managers is minimal will be much lower than optimal because managers enjoy a more comfortable existence by carrying less debt than they can afford to. Conversely, as stockholders acquire power, they will push these firms to borrow more money and, in the process, increase their stock prices.

Do increases in leverage lead to improved efficiency? The answer to this question should provide some insight into whether the argument for added discipline has some basis. Do increases in debt lead to improved efficiency and higher returns on investments? The answer to this question should provide some insight into whether the argument for added discipline has some basis. A number of studies have attempted to answer this question, though most have done so indirectly.

□ Firms that are acquired in hostile takeovers are generally characterized by poor performance in both accounting profitability and stock returns. Bhide (1993), for instance, notes that the return on equity of these firms is 2.2% below their peer group, while the stock returns are 4% below the peer group's returns. While this poor performance by itself does not constitute support for the free cash flow hypothesis,

Palepu (1986) presents evidence that target firms in acquisitions carry less debt than similar firms that are not taken over.

Smith (1990) also find that firms earn higher returns on capital following leveraged buyouts. Denis and Denis (1993) present more direct evidence on improvements in operating performance after leveraged recapitalizations14. In their study of 29 firms that increased debt substantially, they report a median increase in the return on assets of 21.5%. Much of this gain seems to arise out of cutbacks in unproductive capital investments, since the median reduction in capital expenditures of these firms is 35.5%. Of course, we must consider that the evidence presented above is consistent with a number of different hypotheses. For instance, it is possible that the management itself changes at these firms, and that it is the change of management rather than the additional debt that leads to higher investment returns.

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